Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

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1) Trading 101: Starting Your Trading ProgramIn this video, author and professional trader Sunny Harris boils trading system design and analysis down to its most essential rules. In just a little more than an hour, you will discover the elements that are necessary to create a winning system, and you'll find out how you can apply each of these elements to your own trading. In addition, you will learn the 6 trading rules that will give you an edge, the 6 money management rules that will improve any system and the 6 essential steps to test your trading methodology.

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Friday, August 31, 2007

Read an interview with Dr. Van K. Tharp, the author of Trade Your Way to Financial Freedom in his free weekly newsletter for Aug 22, 2007 on his opinion about the current market’s condition and if the interest rate cut will move the market up.I think this article is too good to be missed. There are many important messages there that we can learn from.

Chris Perruna pointed out an interesting statistics corresponds to the best period in a year to start an investment:

If an investor invested $10,000 in the DJIA on November 1 and sold on April 30 every year from 1950 to 2004, they would have earned $492,060. If this same investor did the opposite and had bought on May 1 and sold on October 31 from 1950 to 2004, a $318 loss would have resulted. That is an amazing stat, one that is difficult to fathom. This trend extends outside of the American stock market as an article from December 2002 of the American Economic Review says that such a statistical pattern existed in the U.K. stock market as far back as 1694 and still exists today.

What is the relationship between Historical Volatility (HV) and Implied Volatility (IV)?At a certain point of time, IV is hardly related to HV because IV represents future expectations of stock price movement due to certain reasons, which may not be reflected in Historical Volatility (HV).Remember that IV is a prediction of stock’s volatility for the next 30 trading days, whereas HV is a measure of stock’s volatility over the past 30 trading days.When we’re expecting some important events will happen in the next 30 days (e.g. earnings announcement, FDA approvals, etc.), IV will be relatively high. But this may not be reflected in the “what has happened” during the past 30 days. Hence, we can’t really compare or relate IV vs. HV figures at a particular point of time.

Nevertheless, the highest, lowest & average points of HV usually might provide some benchmarks for IV. Highly volatile stocks tend to have relatively higher IV than less volatile stocks, because highly volatile stocks have higher historical volatility as compared to less volatile stocks.

For example:

Picture courtesy of: www.ivolatility.com

As can be seen in the above pictures, AAPL’s IV numbers (gold colored line) range between 24% to 54%, while its HV figures (blue colored line) also fluctuate in about the same range.In contrast, LMT’s IV varies between 15% to 35%, whereas its HV ranges from 11% to 36%. (Before the recent sell-off starting from mid July, the IV & HV only range between 15% to 24% and 11% to 24%, respectively. During massive sell-off periods, volatilities normally increase across almost all stocks, reflecting greater overall market uncertainties).APPL is more volatile than LMT, as reflected in the Historical Volatility figures, and consequently, AAPL’s Implied Volatilities are generally higher than LMT.

There is no standard figure to determine if IV is high or low across all stocks. Implied volatilities of a stock should be compared against its own previous IV figures, not with the other stocks.For example, IV = 34 can be considered very high for LMT, but it is deemed quite low (average) for AAPL, when it’s compared relatively to its individual stock’s past IV data.

Monday, August 27, 2007

What Is Trading System?A trading system is a systematic system or a set of rules which should be able to answer the following questions:

a) What stock to enter.b) When to enter (Entry strategy).c) How much to enter per position (This is called position sizing, or money management, or bet size).This is meant to limit the size of what you are prepared to lose / risk in any single trade to a percentage of your total trading capital (risk management). If you risk too little per trade, you win little, and hence it will take much longer time to grow your account. If you risk too much, it will put your account into danger. Ideally, it should be somewhere in between.d) When to exit (Exit strategy).Many people emphasize too much on the entry, but have no idea when to exit. Actually, you should pay more attention to exit strategy than to entry strategy. Exit strategy is far more important than Entry strategy.There are 2 types of exits you need think about:* When to exit on your losing position (i.e. Where to put your initial stop loss).* When to exit on your profitable position (i.e. When to take your profit).Is It Important To Have A Trading System?Although, as Chris Perruna suggested, trading system is not the holy grail of trading, it does not mean you don’t need to have a trading system at all.Trading system is still important and necessary, as it can guide traders to be more consistent in how they are trading as well as help keep emotions away from trading.But rather, what it means is that there is no one trading system as the only winning system. You can make money by trading any systems. What’s more important in a trading system is that it must have a positive expectancy (average gains higher than average losses) and good money management (position sizing) / risk management. These are the most crucial aspects of your trading system, which many professionals believe as the holy grails of trading.

Also, another great article from Corey from Afraid To Trade blog. As usual, he also never runs out of excellent posts for our trading education. In this article, he suggested:Be selective with your trade set-ups and entries. Always find a reason for why you take the trade you did. This can help you to ensure you’re taking the highest probability trades and eliminate the trading mistakes that could have been avoided if you had followed your rules or identified a clear reason for the actions you took at the time you took them.

Stock Bandit looked into different perspective in how traders vs. investors define “good” vs. “bad” market”. He has good advices at the last paragraph of the article.

Find out Dr. Bruce Hong’s rules for options trading. You will definitely learn something from it.

Thursday, August 23, 2007

How To Get HV and IV Info (Cont’d)3) optionistics.com.This site provides some tools & data such as:

Option Chain: It provides IV as well as Options Greeks data (Delta, Gamma, Rho, Theta, and Vega) for various strike prices and expiration months (not only near ATM options).

Options Calculator & Probability Calculator.

Volatility Charts.

There are 2 types of Volatility Charts provided in this site (for 1 week, 1 month, 2 months and 3 months windows):

a) Stock Price vs. Implied Volatility (IV) chart.This chart can be found under “Tools” >>“Stock Price History” at the left bar.However, this chart shows no Historical Volatility (HV), and the longest window period of the chart is for 3 months only.

b) Option Price vs. IV chart.This chart can be found under “Tools” >>“Option Price History” at the left bar.The good thing about this chart is that it can provide the Option Theoretical Price & IV chart for various strike prices. As we’ll discuss further in the future, Implied Volatility (IV) does vary by strike price.On top of that, you can also select (from the drop-down menu) other options greeks to be plotted with Option Theoretical Price in case you’d like to analyze the trend of each greeks during the selected period of time.To get the chart, simply type in the Option Symbol (e.g. APVJV is the symbol for AAPL Oct 130 Call).

Pictures courtesy of: optionistics.com.

I’m sure there are many other websites that provides such information for free. In case you know one/s, please feel free to chip in. I’ll compile a list for the benefit of everyone. Thanks in advance. :)

Next topics:What’s the relationship between Historical Volatility (HV) and Implied Volatility (IV)?How to make use of the volatility info to determine if an option is expensive (overpriced) or cheap (underpriced)?How to benefit from volatility changes? How does volatility affect our option strategy consideration?

Wednesday, August 22, 2007

In the previous post, we discussed what volatility is and the differences between Historical Volatility (HV) and Implied Volatility (IV). Now, we’ll carry on with some websites for obtaining volatility information.

How To Get HV and IV InfoThe following are the sources from which I usually find HV and IV info for FREE:

IV and Delta figures for near ATM options (No other Options Greeks info).

Options Calculator.It can be found under “Analysis Service” >> “Basic Calculator” at the left bar.

Volatility Charts.This chart shows Historical Volatility (HV) and Implied Volatility (IV) for 3 months, 6 months, and 1 year window (The charts are located at the right side). Advantage: What I like from the Volatility Chart in this site is that the time-scale (in terms of months) in the horizontal axis is very clear. Hence, it’s easier to make quick comparison between months.Disadvantage: The stock price is plotted separately from HV vs. IV. Not too straightforward for analysis & comparison.

Picture courtesy of: www.ivolatility.com.

2) My options broker: OptionsXpress.Here are volatility related tools / info I use from this site:

Real-time IV figures for various strike prices and expiration months (not only near ATM options).

Options Pricer.This tool can be used to calculate theoretical option’s price (options calculator), as well as to show the real-time Options Greeks data (Delta, Gamma, Rho, Theta, and Vega).

Volatility Chart.This chart shows Historical Volatility (HV) and Implied Volatility (IV) vs. Stock Price for 3 months, 6 months, and 1 year window.Advantage: HV vs. IV vs. stock price, all plotted in one chart. It’s easier for analysis & comparison (e.g. The reason why there is a drastic surge in HV is because of the price gap up / down due to earnings announcement).Disadvantage: The time-scale (in terms of months) in the horizontal axis is not very straightforward. Hence, it’s more difficult to make quick comparison between months.

Yes, in trading, you can be right most of the time, yet still lose money in the end. On the other hand, you can be wrong most of the time, but still making money over the long run. It depends on “how much” you gain when you’re right & how much you lose when you’re wrong, more than on the “how often” you’re right or wrong.

Basically, “being right” is represented by frequent / majority small gains but with occasional large losses, which results in a losing money overall in the long run.In contrast, “making money” corresponds to frequent / majority small losses but with occasional large gains, that causes the trader to make money overall in the long run.

Dr. Brett Steenbarger showed that many people prefer “to be right” in the short run to “making money” over the long run. The psychological need “to be right” (frequent wins) inhibits traders to let the profits run or to accept losses.As he suggested, “the desire for frequent wins causes traders to take profits quickly; the aversion to losing leads to holding losers in hopes of converting them to winners.”

Yes, it’s not easy to overcome the psychological need to be right. Even if one does know that he has a trading system with positive expectancy, which will make money in the long run if he’s consistent, it may not be easy to accept when consecutive, frequent small losses happen in the row. His pride & self-esteem may be hurt. He may also lose his confidence of himself or the system. All this could negatively affect his subsequent trading performance.

This is another good example why trading psychology is important. Professionals even say it’s the most critical aspect of trading success. It’s not the trading system / strategy, market indicators, fundamental / technical analysis, or your outstanding market knowledge that will bring you success in trading. It’s you yourself that matters the most for your trading success.

Thursday, August 16, 2007

WHAT IS VOLATILITY?Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.

In options, there are 2 types of volatility:

1) Historical Volatility (HV), or sometimes called Statistical Volatility (SV): A measure of the fluctuations of the stock price over the past 30 trading days.Therefore, when there is a sharp move in the stock price (up or down) during that period, the Historical Volatility (HV) number will increase drastically.HV is obtained by calculating the standard deviation of historical daily price changes (i.e. daily returns) over the specified period.

2) Implied Volatility (IV): An estimate of the volatility of the stock price for the next 30 trading days.Higher Implied Volatility (IV) reflects a greater expected fluctuation (in either direction) of the underlying stock price. This could be due to earnings announcement is nearing, pending for FDA approvals, or some other important event / news, which is expected to move the stock price drastically.IV can be obtained by finding the volatility figure that makes the theoretical value of an option to be equal to the market price of the option (calculated through Option Calculator / Pricer).(Perhaps that’s why it’s called “Implied Volatility”, because it is the volatility "implied" by the option’s market price).

Both HV and IV are usually expressed as a percentage and annualized. Due to this standardized expression, the figures can be used to compare the volatility across different stocks, regardless of the stock price.

"Being right" does not necessarily mean "making money". In that post, Corey also gives some examples why it is so. But what interests me more is the discussion in the comments of that post, in conjunction with the post from Chris Perruna on “Position Sizing and Expectancy”.

The discussion in that post has triggered me to refer back to one of the favorite books of mine, which is also a popular book among many traders: Trade Your Way to Financial Freedom, by Dr. Van K. Tharp. A “must read” book if you want to create or improve your trading system.

And in that book, I found the following sentences with regards to “being right” that I’d like to quote here:

“There is a strong psychological bias to be right about we do with our investment. In most people, this bias greatly oversides the desire to make a profit overall in our approach, or it inhibits us from reaching our true profit potential. Most people have overwhelming needs to control the market. As a result, they end up with the market controlling them.”

To illustrate that being right does not necessarily mean making money, the book shows one simple & extreme example:Say, there is a system with 90% winning trades (i.e. you get it right) with the average winning trade of $275, and 10% losing trade (i.e. you get it wrong) with the average losing trade of $2700.Can you make money with such system that is 90% accurate, and only 10% of time you’ll be wrong?Let’s count the Expectancy of this system:

The irrelevance of winning percentage is nicely summed up by another legend named George (Soros): it doesn't matter how often you are right or wrong - it only matters how much you make when you are right, versus how much you lose when you are wrong.

Corey himself has recently written a great article about “Frequency vs Magnitude in the markets & in life”, as highlighted in my post "Links Of Reflections".

Therefore, what is more important in a profitable trading system is not the frequency of “being right” (which is normally linked to entry & exit strategy), but whether the system has a positive expectancy and how many opportunities (i.e. number of trades) the system presents, as well as how much to trade on each position (i.e. position sizing / money management), as discussed by Chris Perruna in the abovementioned article.

Entry & exit are important, but they are actually only small parts of the trading system. Hence, we shouldn’t focus too much on entry & exit strategies only, but rather should concentrate more on risk management (i.e. how much to risk per trade), money management / position sizing (i.e. how much to trade or how many shares / contracts per position) and positive expectancy (i.e. average gains higher than average losses).And many professionals say that those are actually the holy grails of trading.

The real purpose of trading is not to make money. If that's your goal you probably struggle with it a lot. But all of the following tend to work.If you goal is to be a great trader, then you probably will do well.If you goal is to use trading as a way to measure your self-development, then you will probably do well.If you just love trading and that's why you do it, then as long as you are willing to work on yourself you will probably do well.Those, in my experience, are the key motivations that bring success in trading.

Are you wondering what he meant by that? Most of us are trading with the intention to make money, aren’t we?

If we think further what he says here, actually it does make sense. This has something to do with how we handle our psychology & emotions.

When we’re trading with the goal in mind of making money, we’re always struggling a lot as our mind is burdened with more stress and our emotions, fear & greed, are getting more attached to trading. As a result, we become more tensed in our decision making. The more tensed we are, the more mistakes we make. The more mistakes we make, the more we cannot make money.

When you love trading, your focus is not on making money. You’ll just work hard and are determined to improve your trading not for the sake of money, but it’s more because you just love it. You’ll focus more on how to manage your risk / losses in order to protect your trading capital (good money management), so that you can still trade as long as possible. And you will just keep on working & working on yourself (psychology & discipline) as well as your trading, learn from it, tweak it, improve it, etc.

Why is it extremely important to work hard on yourself? Because, as mentioned before, the trader itself is the most crucial part of trading. People can learn the same trading system, but the results can be different. What causes different results from the same trading system is the trader itself as a part of the system. Trading psychology is what differentiates winners from losers, even from exactly the same system.

When you do just that, perhaps without your realizing it, your capital will not keep decreasing, but instead it’s growing. Why? Because when you know how to trade well and have had what it takes to trade well, the money would follow you.

Monday, August 6, 2007

Quite often I read articles which tell us that options liquidity can be measured by open interest. Because when options have high open interest, this means there are more people interested in the trade, and as a result, it’s more likely for us to get a better pricing for the trade.

Yes, this is quite true. Normally, the higher the open interest, the more likely we’ll be to trade that option at a narrower spread between bid & ask prices. On the other hand, the lower the open interest, usually there will be a wide spread between bid & ask prices.

However, in many occasions, I found that options with high open interest still have a wide bid-ask spread, i.e. about $0.3 or more.On the other hand, sometimes options with low open interest might have a narrow bid-ask spread too. When I traded such options, the fillings were also quite fast.Therefore, to me, open interest is not really the important criteria to decide whether I should trade the option or not. It’s the spread between bid & ask prices that matters more to me.

Generally, the maximum bid & ask spread I’m willing to accept is $0.20 for ITM options, $0.15 for ATM, and $0.10 for OTM options.So, although the open interest is high, but if the bid-ask spread is too high, I’ll normally pass that trade. On the contrary, even though the open interest is low, but the bid-ask spread is still acceptable, I may still trade that options.But of course, ideally I like to trade options with high open interest and narrow bid-ask spread.

Why getting a narrow spread between bid & ask prices is important?Because this can affect your profitability significantly. Also, it’s important to consider how much the stock price is expected to move versus the bid-ask price spread of the options.

For instance:You expect a stock to increase by $1 within a very short term. If you buy an ATM Call option (delta is 0.5) and the bid-ask spread is $0.4. That means, just to break even, the stock price will need to increase approximately by $0.80 (=$0.4 / 0.5). Should the stock price moves as expected and rises by $1, you’ll only profit about $0.1 [=($1 x 0.5) – 0.4]. If the stock only increases, say, by $0.6, you will still lose money.

On the other hand, if the bid-ask spread is only $0.1, you only need the stock price to move up by about $0.20 (=$0.1 / 0.5) before you can start to profit. If the stock price does rise by $1, you would gain about $0.4 [=($1 x 0.5) – 0.1].

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Options involve substantial risk and are not suitable for all investors.All data & information is deemed accurate but is not warranted or guaranteed. It is your responsibility to assess the accuracy, completeness and usefulness of the content of this site. All data, information, opinion expressed, or website links in this site is for informational purpose only, and is not intended to provide any recommendation to buy or sell a security or to provide investment advice. Nor this site endorses or recommends the services of any brokerage company. This site is not responsible for any losses or damages whatsoever that may be arising from any use of the content of this site or website links in this site. You are solely responsible for your trading outcomes or for any losses, monetary or others, which may be resulting from the use of the content of this site. You must do your own due diligence before committing any investment.